Calling China's Bluff

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Greetings YPNationers! I’m delighted to be here. As a new contributor, I had planned on waiting a few days to post—perhaps dip my toe in next week—but then I saw YPNation contributor Jake Bolinger’s post on one of my favorite topics: China’s U.S. debt holdings. So here I am.

Lots of ink has been spilled fretting about the dangers of China divesting itself from U.S. debt, which could cause the cost of our debt and overall interest rates to spike. If this happened, capital would become more expensive, inhibiting business expansion. This possible fate is often used as a pretext to advocate for deficit reduction in the form of spending cuts (rarely do deficit hawks talk about raising more revenue) to keep the Chinese from getting too nervous about default.

But lost in this explanation is that it’s very much in China’s interest to keep buying U.S. debt. In fact, there are signs they get more out of the deal than we do. 

How so? 

China uses U.S. debt purchases to manipulate its currency—it uses its own currency (the yuan) to purchase dollar-denominated U.S. Treasury securities, which decreases the demand (and thus the value) of the yuan and increases the demand and value of the dollar. This currency manipulation acts to subsidize their exports by making Chinese goods look cheaper to Americans so we buy more of them, which means we buy less domestically-produced goods. In the end, the currency manipulation means more jobs and economic activity in China (and less here).

So how reliant is China on this arrangement? The Communist Party’s continued rule has been possible in part due to strong economic growth, and many analysts have speculated that China’s political stability would be threatened with a growth rate of less than 8 percent.  But if China stopped manipulating its currency, the yuan’s value would fall by about 40 percent relative to the dollar (and 20 percent relative to all world currencies). The bottom line: It would shrink their economy by about 2 percent and inhibit their growth, which in the past has been reliant on exports.

China’s intimations that it might divest from U.S. Treasuries are probably a bluff, and should not be seen as a serious threat to our economic health. On the other hand, reducing spending in the midst of economic weakness would threaten the recovery, and possibly lead to a double-dip recession. But more on that later…
 
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